We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Thursday, September 06, 2007

Let's think for a moment of the concept of a mutual insurance company, and to make my analogy, let's strip it down to something very simple.

Let's say that 5 otherwise unaffiliated hospitals decide to get together to form a mutual insurance company. The newly formed company would insure each hospital against malpractice liability. To make life easy, let's assume each hospital is the same size with the same basic patient mix. In other words, each has about the same potential liability. At least on paper.

Anyway, so each hospital makes an equity contribution to the insurance company, which we'll call Spread Out Our Malpractice Exposure, or SooMe. This money is invested. They form a board by each nominating one person, then the board hires a CEO and hires the staff necessary to run an insurance operation. They also buy a reinsurance policy for liability over some pre-determined limit.

In forming SooMe, the hospitals avoid being at the mercy of outside insurers. And if they collectively keep their malpractice losses low, the investment income from their portfolio could eventually be paid out in dividends. In other words, the hospitals directly benefit from improving their performance. This is as opposed to buying outside insurance, where the insurer would be the only beneficiary from reduced liability.

On the other hand, the owners of SooMe are taking risk on each other. And while the board of SooMe might create certain risk standards or what have you, SooMe would never be able to control its members fully. For example, its possible that some hospitals have better hiring practices than others. Or that one hospital starts accepting more high-risk patients than others. These things would be difficult to control fully. So in forming SooMe, each hospital would have to be comfortable with assuming a portion of the risk of the other hospitals. This probably means becoming quite familiar with the management of each hospital as well as the policies and procedures each has currently in place.

They need to buy the reinsurance policy to protect against the possibility, however likely, that their collective liability swells beyond what they've contributed. In bond parlance, SooMe is in a subordinate position and the reinsurer is in a senior position. Only once SooMe's assets have been drained would the reinsurance kick in. (OK I know it's a bit more complicated than that, but stay with me.)

So notice that the whole thing happens without any tricky off-balance sheet maneuvers. No accounting gimmicks. Nothing nefarious. Just a group of self-motivated agents coming together for mutual benefit.

Now, let's say, as yesterday's post describes, a group of banks got together to form a new company called LoanCo. And LoanCo buys a set of loans from each bank. Wouldn't that be awfully similar to the mutual insurance company described above? The banks have risks they'd like to limit. They aren't actually eliminating risk, because they are putting up the cash to formLoanCo in the first place.

Notice that the banks would have to recognize the losses on the loans sold to LoanCo. Why? Because the other owners of LoanCo wouldn't be willing to overpay for the debt acquired. They'd have to come up with some means of determining market value. Could they agree to inflate the value of all loans sold to LoanCo? They could in theory, but this wouldn't be to any one's advantage. Assume there were 5 banks forming LoanCo, and all 5 sold $10 billion par value in loans to LoanCo. Say that the loans should be worth 90 cents on the dollar, but they are actually sold at par. So from any one bank's perspective, I've sold my $10 billion in loans to LoanCo $1 billion above market value. But at the same time, LoanCo has over paid for the other $40 billion in loans by $4 billion. So I own 20% of a company overvalued by $5 billion. I'm no better off.

So I think that if LoanCo was formed by a group of banks mutually coming together out of their own volition, I see no problem. In fact, I think its brilliant. And the transfer of risk involved in such a maneuver would not be markedly different than other very prevalent risk diversifying strategies, such as self-insurance.

However, if the Fed forces them to come together, or if any other governmental force is involved, then my whole argument is thrown into the pit of Carkoon. I think many of the comments posted on DealJournal roundly criticizing the idea are apt, if the Fed got involved.

And as to the comment by the Ghost of Ken Lay ("Sounds like something I want to do"), remember that the Enron stuff was truly a closed system. Enron formed these off-balance sheet partnerships and Enron was de facto the only owner. So Enron could stuff losses in whatever pocket it wanted, because no one was watching. If a group of banks get together, they check and balance each other. I'm certain that Jamie Dimon won't eat losses just to help out Chuck Prince.

Posted by
Accrued Interest

26 comments:

psychodave
said...

and then, someday, when he grows up, LoanCo might really make good, make his parents proud, maybe join that distinguished group of Primary Dealers ... right alongside Countrywide Securities Corporation

I was worried about a Kabal suddenly being able to mark to model all the dubious paper. Then I read your closing comments:"the Enron stuff was truly a closed system" and "If a group of banks get together, they check and balance each other." I begin to understand why you've worked a bit on this idea.

There are already vulture funds being formed to pick this stuff up and to a large extent it's just going to be staring contest until one side meets the other's price.

If the banks create an intermediary - which will, essentially, be a closed end fund - they will each give up a certain amount of control over how long they're prepared to sit. And selling off their interest in the diversified LoanCo would probably be harder than chipping away at their own holdings individually.

Additionally, contributions to LoanCo probably wouldn't be determined solely on the basis of credit quality and marketability - the capital requirements of the individual banks will have a huge influence on their positions at the bargaining table.

Presumably the banks have a large loss on their positions, but they also have a fat carry. I'd be tempted to build up my capital as best I could - delay dividend increases, stop share buybacks, issue Tier 1 Capital - and tell the market I'm prepared to sit on the paper until frickin' maturity if I have to.

If I put it in LoanCo, I'm telling Mr. Hedgie I'm scared and hoping to unwind.

The problem lies in the fact loanco is created by banks, which have the ability to create money. When banks begin moving liabilities off the balance sheet they are essentially under reserving and not in compliance with reserve requirements. If a bank goes belly up then the taxpayers have to eat the cost through higher taxes etc..., if an medical insurance group goes belly up, some people are out of a job.

The banks have carry on these positions for certain, but the reason securitization has been so successful for them is because it gave a great way to turnover assets.

So for example, lets say a bank originates $1bn in loans to securitize. By securitizing they realize between 1 to 2 points of profit. Loans are freed from balance sheet and they are free to do it again. Originate, securitize, 1 to 2 points profit...rinse repeat. In CMBS Morgan Stanley leads the league tables in the 1st half with about $27bn in issuance, first half '07. I imagine their profit margin has been much lower this year, and probably negative with recent deals because spreads have widened out so much on them. Oh yeah, they also would make money on loan origination fees as well, not included in the 1 to 2 pts. Historically this has been a money machine.

Now compare this to your carry situation, you have $1bn in balance sheet eaten up for a year with say 1 pt of carry, which seems high to me. Unless your hedged (which would cost you), the whole $1bn is eating up balance sheet. This will cause some pretty crappy ROA numbers for your stock. Thats why banks are sucking wind now; they may have to sit with these loans eating up balance sheet, creating a drag on earnings and ROA and probably a bunch of other fancy ratios.

Their asset value would not change, to a first approximation but they might have to start marking-to-market (if they haven't done so already).

I'm not sure if their risk-weighted assets would change; they might be decreased. Risk-weighting rules favour securitization for mortgages; I'm not enough of a specialist to know off-hand whether the same applies to loans - especially when there aren't thousands and thousands of these loans to securitize.

TDDG, great blog, you're creating some great discussion and have a good collection of commentors.

I also like the idea of a Loanco. Its actually similar to a conduit (SIV) vehicle. Many of these were bank issued vehicles that were financed via ABCP mkt. Balance sheet was freed up and risk was taken by the conduit shifted to CP investors. Obviously that business model is not in such good shape because the assets being pledeged to the vehicles are now in question, but that shouldn't be a problem for a loanco since this is capitalized by equity investments. The bigger issue the fact that all the banks have different collateral and will not likely agree on the prices of each other's debt contribution. That will be one crazy round table...

dcsr - For sure, the banks would much rather securitize and get rid of the loans, I'm not denying that.

I'm just thinking about maximizing the price when they do so. I don't know the term on these loans - maybe 5 years? Call it a modified duration of 4.25?

And maybe there's a risk weight of 8% for the credit, 3% for term, so on a $10-billion loan, risk-weighted assets are $1.1-billion so they've got to put up about $100-million capital to maintain their ratios. [Feel free to make fun of these numbers - I'm not a specialist and am just looking at a BIS document].

So first off, the return on capital from the carry isn't all that bad: 2% carry implies 200% return on capital.

I know they don't want the carry; I know that's not the business they want to be in. But that is the business in which they find themselves right now, willy-nilly.

More importantly, though, if they can lower the yield on a sale by 50bp on the 5-year loan, that's $200-million right away; and if they can make a credible case to the market that they're prepared to carry the loan, they've got a better chance of getting that 50bp reduction in spread.

Again, feel free to make fun of and change the numbers; I'm not a junk specialist, let alone a US junk specialist; I won't be offended.

I have, however, traded one or two bonds in my life, and wouldn't want to be the guy saying 'Gee, Mr. Kravis, the boss says I've got to sell these bonds by 5pm, what do you bid?'

I may be wrong, but I don't think putting the loans into LoanCo will, in and of itself, free up any balance sheet room. The size of their equity investment in LoanCo will be identical to the size of their fixed income investment in the loans held directly - unless they can obtain financing for LoanCo from other investors.

They might be able to get such financing, but as you say, that simply turns LoanCo into a SIV. That's one way to securitize, but I'm not convinced it's the fastest or surest way to get the stuff off their books completely.

I love the conversation. I feel as though I've said my peace in the post so I won't add much here.

1) LoanCo would be in essense a self-funded SIV or CDO.

2) The bridge loan problem isn't so large that it threatens these banks. Remember that the bridge lenders are only very large banks. Its more than they don't want them on their balance sheet for the next 10 years.

3) As dscr points out, I doubt very seriously that they'd be able to actually get together to form LoanCo. The more likely scenario is that banks work with some private equity types to put together a more independent version of LoanCo.

I thought your comment was annoying because it has no substance. You give no basis for your thoughts. I may as well claim a volcano is going to erupt under New York.

FYI, the fastest way to tell an investment pro that you are an amateur is to claim 1987 is about to happen again. We hear people claim this so often that it becomes like the guy holding an "end is near" sign on the corner. If you want to claim we're going into a long bear market, there is a legitimate case to be made. But 1987? There was such a strange confluence of factors that caused that specific crash. So to draw the conclusion that we're repeating that is tough. Very tough.

Cripes. Greenspan was not saying 1987 is about to happen again. He's comparing today to other liquidity crises. If anything we should consider his comparison when thinking about how the Fed will react.

I was merely implying that there is no love lost between them. The rich are only clubby with each other as long as it is beneficial to do so. Anyway, if you are trying to claim Dimon/Prince/Me are self-interested, guilty as charged.

An increase in the transactions velocity of money (Vt) occurs/follows with most injections of legal reserves - even when temporary additions are "washed out". The 2 week infusion of excess legal reserves ending 8/15 stalled, and will minimize, any protracted drop in real-gdp. The present and temporary decline in the rate-of-change in monetary flows (MVt) will therefore not be as steep as anticipated. The current downswing in the economy ends Oct. 07. However, expect that the 4th qtr economic rebound will still be sharp.

Toxic assets are "lemon" products and lemon banking (read on my blog): who is going to buy a lemon? Why support to lemons? Too much asymmetry in information not to say little information on these assets...Under these circumstances any auction and pricing is doomed to fail.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.